When owners think about transitioning the ownership of their businesses to insiders or to an external buyer, they don’t often realize just how much of their hard-earned wealth will go toward paying taxes. Owners don’t need to be tax experts, since they can rely on their CPA to do the detailed calculations, but they do need to have a basic understanding of how business transfers are taxed so they can assess different transfer options and understand how much they will “net” from each. This is a very important number. If it is not enough and the sale is consummated, owners may be forced to continue to work in some capacity or reduce their lifestyle in order to have enough money to live the rest of their lives.
Fundamentals of Transfer Taxes
The type of corporate entity and the way the transfer is structured are the primary drivers for how the transaction will be taxed. “Pass through” entities such as S corporations, limited liability companies (LLCs) and partnerships are taxed differently than C Corporations. Transactions structured as asset sales are taxed differently than stock sales or stock redemptions and there is a way for stock sales to be taxed as asset sales! Sellers typically want to sell stock so they can receive capital gains instead of ordinary income tax treatment and buyers typically want to buy assets so they can depreciate the assets and avoid taking on the seller’s liabilities.
If owners sell their stock, the amount that is taxed is the difference between the selling price and the “tax basis” of the stock. In a C corporation, the basis is what the owners paid for the stock and it does not usually change over time. In pass through entities, stock basis goes up when the company makes money and goes down when owners take distributions so it is an ever-changing number.
Understanding the fundamentals of how business transfers are taxed will enable owners to evaluate the components of buyers’ offers much more thoroughly and negotiate accordingly. For example, transfers may include multiple types of income streams for the sellers such as cash down payments, note payments, consulting fees, salaries, bonuses, benefits, earnout payments, etc. and these are taxed differently.
What Owners Can Do
Transfer taxes is a very complex area. There are numerous nuances and owners should never attempt to do the calculations themselves. Owners should seek education in this area well before they attempt to sell their businesses either internally or externally. We cover transfer taxes in our training courses and owners could start by meeting with their CPA to discuss their current tax situation and find out:
What type of entity they own
The current tax basis of their stock and business assets
How much tax they would have to pay under different business transfer scenarios and for different income streams
Understanding business transfer taxes is probably not high on most owners’ lists of things to do but those owners who are contemplating a sale of any kind, in the future, would be wise to spend some time on this important topic. After all, the tax bite is often at least 30% and can be as high as 50 or 60% of the sale proceeds! However, there are tax planning techniques that can be employed before the transaction to keep taxes to a minimum and negotiating that can be done during the transaction to minimize taxes as well. We cannot over-emphasize the importance of this topic for owners. If owners make an effort to get properly educated on this topic, they will most likely receive an excellent return on their time and effort in the form of significant tax savings and hard-earned wealth preserved!